Aug. 16 (Bloomberg) -- The Bank of Japan, struggling to
keep the strengthening yen from derailing efforts to repair the
world’s third-largest economy, is facing a new challenge -- the
shrinking yield gap between two-year sovereigns and Treasuries.

The extra yield two-year Treasuries offer over similar-maturity Japanese notes fell today to the least since 1992. BOJ
Governor Masaaki Shirakawa said on Aug. 4 there’s a “relatively
high” correlation between that rate gap and the dollar-yen
rate, as falling yield premiums in the U.S. damp dollar-buying
demand from Japanese investors.

The central bank may need to lengthen the maturity of bonds
in its asset purchase program to stop the yen’s appreciation,
according to Mizuho Securities Co. The BOJ, whose policy rate is
already near zero, bolstered stimulus by 10 trillion yen ($130
billion) on Aug. 4, the same day Japan intervened in the
currency market for the first time since March.

“It’s significant that Governor Shirakawa discussed the
Japan-U.S. interest rate gap, and specifically the two-year
term, at a time when the yen is strengthening,” said Naomi
Hasegawa, a senior bond strategist at Mitsubishi UFJ Morgan
Stanley Securities Co. in Tokyo.

The difference between the U.S. and Japanese two-year
yields narrowed to a 19-year low of 3.7 basis points today.

U.S. two-year Treasury note yields dropped to a record low
of 0.1568 percent after the Fed pledged on Aug. 9 to keep its
benchmark interest rate at an all-time low at least through
mid-2013 to aid the economy’s recovery. It was at 0.1869 percent
today while Japanese two-year notes yielded 0.15 percent,
according to Bloomberg data.

Bond Buyer

The central bank could increase the remaining maturity of
government bonds it buys under its asset-purchase program to
between two to three years from up to two years now, said
Yasunari Ueno, chief market economist at Mizuho Securities in
Tokyo. It could also lower the 0.1 percent rate the BOJ pays
banks for keeping funds in its accounts, encouraging them to
invest and lend more, he said.

Buying longer bonds would be in line with the
recommendations of the International Monetary Fund, which last
month said the central bank could “ward off deflation risks and
support the recovery” by increasing purchases of government
bonds with maturities of three years or more.

Japan’s central bank raised by 5 trillion yen a fund to buy
assets such as government debt, corporate bonds and real estate
investment trusts, while also boosting by the same amount on
Aug. 4 a program to encourage banks to lend. Two-thirds of the
15 trillion yen asset-buying program is earmarked for buying
Japanese government debt.

‘High Uncertainty’

In expanding its stimulus measures this month, the BOJ said
there’s “high uncertainty” surrounding the economic outlook.
Companies cut production and consumers held off from making
purchases after a temblor and tsunami hit the nation’s northeast
coast, causing an estimated 16.9 trillion yen in damage and
triggering the worst nuclear crisis since Chernobyl.

Japan’s economy shrank at a 1.3 percent annual pace in the
three months through June, the third straight quarter of
declines, the Cabinet Office said yesterday. It will probably
rebound in the second half, according to a Bloomberg survey.

A climbing yen is an additional risk for Japan’s export-dependent recovery. The currency strengthened to as much as
76.31 per dollar on Aug. 11, near the post-World War II high of
76.25 in March that prompted the Group of Seven nations to
jointly sell yen. It traded at 76.88 today in Tokyo.

Yen ‘Beyond 75’

“The yen may appreciate further, beyond 75,” Eisuke
Sakakibara, a former Japanese currency official, said in an
interview with Bloomberg Television yesterday. “I would expect
the U.S. economy to be fairly weak for a long period of time.”

There’s limit to how much the two-year rate could fall if
the BOJ continues to pay a 0.1 percent interest on deposits,
since banks may keep their money in the BOJ account, said Mizuho
Securities’ Ueno.

Still, reflecting the continued decrease in short-term
market rates, the spread between the Bank of Japan’s target of
unsecured overnight call rates and three-month euroyen futures
narrowed to a nine-month low of 20 basis points from a peak of
31.5 basis points in December.

The yield on Japan’s benchmark 10-year bond was little
changed at 1.035 percent today, from this year’s low of 0.975
percent on Aug. 9, and 1.05 percent on Aug. 12, the most in two
weeks. Ten-year Treasury yields declined one basis point to 2.30
percent, from a record 2.03 percent on Aug. 9.

Five-year contracts to insure Japanese government bonds
against default fell 3 basis points to 105 basis points in New
York yesterday, according to data by CMA, which is owned by CME
Group Inc. and compiles prices quoted by dealers in the
privately negotiated market.